Essays on Liquidity in Financial Markets

Abstract

The smooth functioning of financial markets and market efficiency hinge on the ability of market places to limit trading frictions. Liquidity measures the degree of frictions and is an important, if not the most important, measure of market quality. It is a parameter of great relevance for market places wanting to attract order flow from investors, possibly to the detriment of competing trading venues. Liquidity is important for traders since it determines their transaction costs. Besides, investors and firms care about liquidity because of its link to asset pricing. Therefore, the question of how to increase the liquidity of a market place has been widely investigated in recent years. By designing appropriate rules exchanges can help to increase the liquidity of their market and to attract order flow from investors.<br /> This dissertation provides new empirical evidence on the determinants of liquidity within a given market and on liquidity migration between competing trading platforms. It concentrates on aspects which have become relevant due to the proliferation of electronic limit order platforms and ongoing changes in market design and political market regulation.<br /> In particular, one important market design issue for electronic limit order markets is the question of whether or not to implement hybrid market structures. Chapter 1 examines liquidity provision in a hybrid order driven market where designated sponsors (mandated by Deutsche Börse AG) compete with other designated liquidity providers and the limit order book. It employs panel data analysis in order to cope with an endogeneity problem that is typically encountered by the literature. Results promote the use of multiple designated market makers on electronic limit order platforms.<br /> The next chapters analyze liquidity on competing exchanges. Chapter 2 contains the first market microstructure analysis of the world’s largest market for CO2 emission rights. Next to providing an overview of the development of CO2 trading in Europe from 2005 to 2007, Chapter 2 analyzes liquidity and price discovery in this recent market. Results suggest that from a trading perspective, the market has made a lot of progress since its operational start in 2005. <br /> The third chapter relates to the recent European MiFID regulation. It analyzes the market entry of the pan-European equity trading platform Turquoise, competing for order flow with primary stock exchanges of 14 European countries. Chapter 3 investigates determinants of success of a new entrant and provides new evidence on whether enhanced competition increases market quality in the primary markets. <br /> Overall, by shedding light on determinants of market frictions, the results of this dissertation can give guidance for platform providers, political regulators as well as investors choosing their preferred trading venue. They are thus of interest beyond the academic world. This applies to the findings of Chapter 1 in which evidence is provided that a particular market design can increase liquidity in that market. It also applies to the results of Chapters 2 and 3 which indicate that regarding competition for order flow, changes in market organization have rather weak effects, if any.